Factors that influence inflation rate & its implications for investors

Vikas Agarwal, ET BureauMar 7, 2010, 04.34am IST

The Wholesale Price Index (WPI) based inflation rate is rising steeply ever since it came into positive territory in September last year. The monthly WPI-based inflation was reported at 8.5 percent in February. Analysts believe the inflation rate is likely to remain firm in the medium term mainly due to last year's low base effect and other driving factors such as high food price inflation, recovery in the global economy and high liquidity.

These are some of the major factors that are expected to influence the inflation rate movements in short to medium terms:

Food articles inflation

Inflation in food articles is one of the main drivers of the WPI inflation. Food articles inflation was triggered by a shortfall in the monsoon last year. Analysts are expecting a good monsoon this year due to the fading of the El-Nino effect.

Although there are remote chances of any major softening in prices, last years' base effect coupled with a good crop this year is expected to bring down the inflation rate in the next few months. Therefore, the monsoon is an important factor.

Commodity prices

The prices of commodities are expected to come back as the global economy is slowly getting back to the growth path. Crude oil, metals and precious metals like gold and silver have already gone up quite significantly in the recent past. Higher prices of these commodities abroad will have a cascading effect on other commodity prices, and hence result in higher inflation.

Liquidity

High liquidity and higher disposable incomes are other factors that would keep the inflation rate firm in the medium term. The spending on the government's fiscal stimulus packages and fund inflows from foreign institutional investors (FIIs) has resulted in a surge in liquidity in the economy. The tax cuts will put more money in the hands of consumers.

In short, the inflation situation does not look like it will come under control in the near term. The implications of a higher inflation rate are quite widespread.

These are some of the implications:

Harder interest rates

The Reserve Bank of India (RBI) has already started a tightening in the monetary policy. Although the RBI has indicated that the interest rates would be increased slowly, in a phased manner, many analysts believe the current scenario of soft interest rates is not going to last long. The RBI could trigger a rate hike in its policy review next month.

Impact on stock markets

A rise in the inflation rate impacts market sentiments. A higher inflation rate helps in driving the interest rates higher and hence borrowing becomes costly both for the market or financial institutions. Therefore, the valuations of capital-intensive companies and sectors come under pressure as their margins decrease due to the higher interest burden.

However, the markets are governed by many factors and the direction cannot be determined by reading just one factor. Global sentiments and global funds inflows are other crucial factors that impact the direction of stock markets significantly.

Commodity prices

The prices of many essential and primary commodities have shot up quite significantly in the last one year. The prices of basic food commodities are still hovering near the 20 percent mark. All income categories are facing the brunt of rising prices. Inflation hits retired people and those with fixed incomes very badly.

Uncontrolled inflation destabilises the economy as consumers and investors change their spending habits. The government and the RBI are working on measures to control the inflation rate and it is important for investors to track the developments around inflation to get a feel of the direction of the economy.